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27 Nov 2015

Carbon market mechanisms matter for Paris COP

Liza (email) graduated from LUC last year (she's now at Edinburgh University). I asked her to write a little about her bachelor thesis since her topic is so relevant to the upcoming climate talks in Paris. -- David
The table below summarizes four case studies discussed in my bachelor thesis “Market mechanisms for greenhouse gas emission control: carbon tax vs. cap-and-trade”. Market mechanisms for GHG emission control are currently not widely used, but they hold great potential.

In the literature, there are various arguments for preferring either a carbon tax or a cap-and-trade scheme, but they usually boil down to the tons of CO2 reduced and the revenue produced. Cap-and-trade is usually preferred because CO2 emission reductions can be set as the aim, while a carbon tax is preferred because it will raise higher (and predictable) revenues. From the table above it can observed that cap-and-trade schemes reduce more tons of CO2 per year, while carbon tax schemes have higher annual revenues. These observations correspond to the arguments that are found in the literature, meaning that to an extent practice does follow theory. However, the success or failure of a particular market mechanism cannot be attributed to only these two factors. For example, Australian carbon tax raised high revenue and reduced CO2 emissions, but it was revoked due to a lack of political support for the scheme.*

Furthermore, the use of revenue is very important for the success of a market mechanism, particularly for carbon taxes. The Australian tax was revenue positive, which meant that the revenue raised went into the national budget from where it was very hard to follow spending. The BC tax on the other hand, was revenue neutral. The revenue was used to reduce other taxes on citizens and corporations. Cap-and-trade schemes also often fund sustainability projects. Citizens tend to support market mechanisms that recycle revenue into sustainable development, thereby strengthening political will to keep the mechanisms going.

Businesses don’t like cap-and-trade schemes because under them, the price they pay for carbon is uncertain and their ability to plan long-term is hampered. In order to get businesses on board with cap-and-trade schemes, governments often give away initial permits for free. Both the EU’s ETS and California’s cap-and-trade schemes had this feature. Free permits may raise business compliance, but they also mean lower initial revenues. Free permits have to end at some point, of course, if one wants businesses (or consumers) to face price incentives to lower their emissions.

When a market mechanism is introduced as a policy, it usually already has a long-term plan of how the policy will work and how it aims to affect emissions; this is done with trajectories. Both EU ETS and British Columbia have trajectories – the former with how the cap decreases over time and the latter with how the tax grows over time. Trajectories can give a sense of security to those worried about impacts over several years. However, their correct establishment can be very tricky, particularly when it comes to carbon dioxide, because there is much scientific uncertainty about the “tipping point of emissions” and there is no consensus on who is responsible for the impact of emissions (and how much).

When it comes to worldwide cooperation for GHG control, it is not a question of which nations emit because they all do. The question is – how high are the emissions relative to each other and with regards to the potential threshold of devastating consequences. If only a number of countries act to control their carbon emissions, and these countries are not the big emitters, then the effect on the global carbon emissions will be very small. Also, if only a few countries establish market mechanisms for carbon emission control, there is always the potential for “leaks”. This is to say that businesses will try moving their activities to countries that do not regulate carbon emissions – lowering their emissions on paper (in the regulated nation) but not globally. For this reason, it is advised that if market mechanisms are to be used, they have to be created everywhere worldwide. And depending on which market mechanism is used the price or the cap has to be synchronized around the world. This will limit the number of “leaks” in the different systems and potential spillovers will be avoided.

The synchronization of the price/cap does not mean that the different systems need to be linked in a global market. Taxes might be easier to impose on a national level, without connecting as it ensures that the revenue raised is used locally (and revenue neutrality can be ensured). Cap-and-trade systems on the other hand, could be linked together. This is already happening by California’s scheme being linked with Quebec’s; and it is likely that more cap-and-trade systems will be linked together later on.

Which system should a country choose? A carbon tax “bites” (generates revenue) immediately and can be enforced a lot more quickly (as seen in the table above). Cap and trade (assuming a low enough cap) makes it easier to harvest “low hanging fruit” at a low business and political cost. The choice is not as important as making a choice, as the first priority is to get nations around the world to impose some downward pressure on carbon emissions.

Bottom line: The theoretical character of a carbon tax or cap and trade will not determine if it succeeds as much as implementation and use of revenues. I therefore have hope that the delegates meeting in Paris can find ways to implement market mechanisms that will reduce carbon emissions within domestic political constraints.
* On Australia’s failed tax scheme: Prime Minister’s in Australia change more often than Defense Against the Dark Arts professors at Hogwarts, and the last change happened back in September. While the ruling party did not change, the new PM has promised to revisit (and potentially change) Australia’s climate policies; however, it is unclear what exactly this means and if it will include the renewal of the carbon tax. Greens have recently conducted some modeling, to provide data in support of the carbon tax. They find that re-instating the carbon tax will produce just as much revenue as changing the GST, while costing households a lot less. If the main concern of the Australian government is to increase their budget while making sure that the general population can afford it, it appears that re-introducing the carbon tax would be the way to go.

1 comment:

"Free permits have to end at some point, of course, if one wants businesses (or consumers) to face price incentives to lower their emissions." I have doubts about this: even permits obtained for free represent costs to the emitter: opportunity costs. If he uses the permits for his emissions, he cannot sell them and thus he foregoes the revenues, and thus he has a price incentive to reduce his emissions. Permits for free or auctioned are thus in my opinion just a matter of distribution, but can be used to convince ('bribe')businesses to support the scheme.Greetings, Michiel Wind